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Ambarella Faces Tough Competition

Ambarella stock has soared of late, but investors seem to be missing the stiff challenges ahead.

Ambarella(NASDAQ:AMBA) has staged a terrific turnaround since the beginning of September. Shares of the video processing chip specialist have risen almost 35% after a report of poor performance sent the stock down 22% in a day.

That puts the stock up almost 8% so far this year. There seem to be two possible reasons for the impressive post-earnings rally.

First, investors saw an opportunity in the post-earnings drop, believing that the company is built for long-term growth because it supplies chips to fast-growing industries such as drones, action cameras, automotive, and others. Second, investors gave the stock a shot in the arm after Canaccord Genuity analyst Matt Ramsay on Oct. 12 upgraded his price target from $58 to $65, maintaining a buy rating. Ambarella stock closed Nov. 24 at $58.44.

Ramsay believes that the market hasn't recognized Ambarella's true growth potential, as well as its engineering and research expertise in computer vision technology. While Ramsay's arguments are true to an extent, I think he is failing to properly weight the challenges Ambarella faces. That the company was forced to slash its full-year outlook in September despite focusing on fast-growing markets should have sent alarm bells ringing.

Image source: Ambarella.

Ambarella is losing ground in key markets

It's common knowledge that well-known Ambarella customers have been shopping around for chips. The company was a key supplier to market leaders such as GoPro (action cameras), DJI Innovations (drones), and Hikvision (security cameras), but all of them have tapped other component suppliers for their latest products.

GoPro, for instance, cut Ambarella out of its latest flagship action camera, the Hero 6, by making a custom chip of its own. DJI, on the other hand, used an Intel(NASDAQ:INTC) chip in its latest budget mass-market drone, the Spark. That means Ambarella is missing out on an opportunity to tap growth in the drone and action-camera markets, which are expected to grow at compound annual growth rates of 7.6% and 23%, respectively, until 2021.

Not surprisingly, Ambarella is now forecasting full-year revenue to decline 3% to 7%, compared with its earlier expectation of a flat performance. The company has clearly stated that the introduction of lower-priced drones, such as the DJI Spark, will reduce demand for its chips, and Ambarella isn't prepared to tap this space right now, since it's busy developing a high-end chip to target drones, security cameras, and the automotive markets.

However, Ambarella has bigger rivals to contend with in all these markets, which is why investors shouldn't bet the company's future on just one product.

The computer vision chip doesn't guarantee a comeback

Ambarella is pinning its hope on the CV1 computer vision chip that it plans to start sampling in the fourth quarter. The company expects this chip platform to help it tap growth across a variety of markets, but it's going to run into stiff competition from deep-pocketed rivals with long client lists and years of research and development expertise.

Ambarella has spent four years developing the CV1 chip to take advantage of the fast-growing computer vision market. This space could hit almost $49 billion in revenue by 2022 thanks to applications in automotive, consumer electronics, and robotics. The estimate might look very rosy on paper, but Ambarella might be left looking for the low-hanging fruit as Intel is busy capturing most of the available opportunity.

Intel snatched a win from Ambarella in the drone market when DJI used the Myriad 2 computer vision chip from its Movidius subsidiary. Now, Intel has pushed its computer vision technology further with the Myriad X that's twice as powerful as the Myriad 2, allowing users to interpret surrounding information at a faster pace thanks to its deep learning capabilities.

Therefore, Intel is already ahead of Ambarella in the computer vision chip market, and it could effectively hurt the latter's prospects in the automotive space because of its formidable automotive alliance.

As a result, Ambarella will find it difficult to match up to Intel, as it's just getting started, and it doesn't have an identical partner ecosystem backing its chip right now. Moreover, Ambarella's CV1 chip isn't expected to generate revenue anytime soon, as it will be first showcased to a broader audience only in January.

That means Intel will have time to further improve its technology, land more clients, and gobble up more of Ambarella's opportunity.

Ambarella trades at an expensive price-to-earnings ratio of 37, higher than the 25.7 industry average. For a company whose business is on the wane because of the loss of customers, and which might find it difficult to execute a turnaround thanks to stiff competition, this is a pretty expensive price to pay. Ambarella is set to report earnings on Nov. 30. Investors will want to tune in to see how things are going.

Harsh Chauhan has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Ambarella and GoPro. The Motley Fool recommends Intel. The Motley Fool has a disclosure policy.